Week in review: Walmart highlights need for decisive Fed

Make no mistake, this is one of the most important weeks of the year for traders and could determine the direction of global stock and FX markets for weeks to come. Firstly, we have a raft of tech earnings later this week, including Apple, Microsoft, Google parent Alphabet and Amazon. Since they have an out-sized presence in the S&P 500, their fortunes could determine Q2 earnings season and how it impacts the future price direction. On Wednesday, we get the latest Fed meeting, which is expected to see another 75 bp rate hike. In the background are further concerns about the impact of inflation on the retail sector after Walmart issued its second profit warning in 10 weeks, causing its stock price to sink 8% in after-hours trading on Monday.

Walmart profit warning is a sign of the US consumer under pressure

Looking at the final point first, Walmart’s profit warning was ugly. It expects operating income to fall by 13-14% in Q2, and a drop of 11-12% for the full year. This is significantly worse than what the company had predicted in May, when it said that operating income could be slightly higher for Q2, and overall operating income would only be down by 1% this year. The reason for the decline is the cost-of-living crisis hurting price sensitive consumers who are spending their income on fuel and food rather than clothing and other non-essential items. Walmart’s CEO said that it was discounting heavily to clear an inventory backlog, including clothing. Another problem is that companies like Walmart are ordering Christmas merchandise early to avoid supply chain disruptions, however, demand is not keeping pace and retailers are having to discount heavily to shift their goods.

Walmart is a bellwether stock for the health of the US consumer, after its first profit warning in May, where its stock had its largest 1-day drop since 1987, the share price had not managed to recover. This is a sign that the market remained downbeat on the outlook for the average US consumer even before Monday’s profit warning. Due to Walmart’s position as the US’s largest retailer, its fortunes also impact its peers. Target, Lowes and Amazon all fell sharply on the back of the Walmart news. Walmart will also take a $1bn hit on the stronger dollar, which is impacting foreign income, for Q2. Overall, it expects another $1.8bn loss caused by the stronger dollar in the second half of this year.

Walmart’s inflation problem

The problem for Walmart isn’t that people aren’t visiting their stores, it’s what they are buying. After adjusting for fuel sales, Walmart expects its US sales to be up by 6% in Q2, higher than previously expected. However, this is driven mostly by food sales, which is experiencing double-digit inflation, and generates lower profit margins compared to other sales categories. Walmart’s CEO said that he expects a decent back-to-school sales season, however, this is unlikely to boost general sales too much, as he expects them to remain subdued for the rest of this year. Walmart’s profit warning highlights the dilemma for the Fed: if it suggests that interest rates will continue to rise at this rapid pace for the rest of this year then it is likely to trigger another leg lower for stocks as recession risks come to the fore. However, if it doesn’t act decisively enough through the rest of this year, then it could increase fears that inflation will continue to surge, which puts more pressure on certain parts of the US economy like retail. Interestingly, components of the S&P 500 are not equal in the current environment, while retail stocks have tanked, JP Morgan and Citi rose at the start of the week as they benefit from higher lending costs.

The Fed: upwardly adjusting future rate hikes expectations

We will spend more time on the Fed after we hear from them on Wednesday, as we trust that you have your fill of Fed previews. The key things to remember going into this meeting include inflation which is running hot, above 9%, employment growth is strong even though the housing market in the US is showing signs of weakness and strain. Also, according to CME Fedwatch, there is a 77.5% chance that the Fed will raise rates by 75bps to 2.25-2.5%, there is only a 22.5% chance of a 100bp rate increase. Thus, if the Fed does opt for a larger rate rise, it would be a shock to the market. The market expects the size of rate increases to slow after this meeting, with a 40% chance of rates rising to 3.25-3.5% at year end. There is only a 1.1% chance that US rates will rise to 4% by year-end, which we think is too low. If the Fed wants to prep the market for higher rates this year, then it needs to move the dial on where the market expects rates to end the year. If it sounds hawkish and committed to a long fight against inflation, then we may see rate expectations adjust higher, bond yields could surge, stocks may tank, and the dollar could be king once more.

Earnings season: oil majors the new tech titans

As we mention above, earnings season is also in full swing. Google and Microsoft are already warning the market that investment levels will be lower going forward, while Apple has already prepped the market for lower levels of growth compared to last year’s breakneck speed. The mood music is negative, and if these titans can’t deliver a decent set of earnings in this economic environment, then forward earnings for the rest of 2022 could be adjusted lower, which may be another card that falls from the global stock market. Interestingly, according to FactSet, S&P 500 companies that generate more than 50% of their sales outside of the US, have seen their earnings growth so far in Q2 exceed 10%. This is compared to companies that generate less than 50% of their income outside of the US, where sales growth is a mere 1.8% so far in the US Q2 earnings season. This compared with the average earnings rate so far for S&P 500 companies of 4.8%. This finding is strange, since one could assume that the war in Ukraine along with the strong dollar would hurt the earnings of companies that generate their income outside of the US. The reason for this anomaly is the oil majors, including Exxon Mobil and Chevron, who generate more than 50% of their earnings outside of the US and who have massively benefitted from the continued elevated oil price in recent months. Thus, we do not think that other large multi-nationals in the tech space can repeat what the oil majors have achieved, so don’t expect fireworks from the tech titans later this week. It does suggest that Q2 earnings season could look good for the FTSE 100, which has a large energy sector.